Chinese Estates Holdings (HKG:127) Has A Pretty Healthy Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Chinese Estates Holdings Limited (HKG:127) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Chinese Estates Holdings

How Much Debt Does Chinese Estates Holdings Carry?

The image below, which you can click on for greater detail, shows that Chinese Estates Holdings had debt of HK$7.26b at the end of December 2020, a reduction from HK$13.4b over a year. However, it does have HK$3.58b in cash offsetting this, leading to net debt of about HK$3.69b.

How Healthy Is Chinese Estates Holdings' Balance Sheet?

We can see from the most recent balance sheet that Chinese Estates Holdings had liabilities of HK$5.78b falling due within a year, and liabilities of HK$2.91b due beyond that. Offsetting this, it had HK$3.58b in cash and HK$235.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$4.88b.

This is a mountain of leverage relative to its market capitalization of HK$7.57b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Chinese Estates Holdings has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 13.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Chinese Estates Holdings grew its EBIT by 477% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is Chinese Estates Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Chinese Estates Holdings produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Chinese Estates Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. When we consider the range of factors above, it looks like Chinese Estates Holdings is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Chinese Estates Holdings is showing 3 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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